Gabriela Cavalcanti

Du Miracle de L’asie à la (Re)Orientation Du Monde

___________________________________________________________

The 2008 Financial Crisis

Why Economists Got It All Wrong?
After two decades of prosperity around the world,

rising defaults on subprime mortgages in the U.S generated

a global crisis that is the worst in 75 years. The 2008

financial crisis, more than an economic event, has put

pressure on the geopolitical system, driving states to

change their behaviors.1 The current financial crisis came

as surprise to most people because renowned economists have

been affirming, for the past twenty years, that the central

problem of depression-prevention had been already solved.2

3
They were proven to be wrong. This topic is important

because its analysis confirms a pattern in economic cycles:

periods of abundance are followed by economical slumps. The

subprime crisis exemplifies the historical pattern all too

well and this paper shows it since the tumultuous

twenties.4

Based on that, this paper will examine the 1929 Great

Depression, the 1997 Asian Financial crisis and the 2008

financial turmoil to show that, although different, they

1
“Political Economy and the Financial Crisis.” Stratfor.com. Seen at:
http://www.stratfor.com/theme/global_financial_crisis
2
Krugman, Paul. “How Did Economists Get It So Wrong?” The New York
Times. September 2,2009.
3
IBID.
4
Baldwin, Richard. “Calomiris on historical crisis lessons.” November,
4th 2009. http://www.voxeu.org/index.php?
q=node/4157

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are there to remind us that economic cycles are not over.

Also, based on empirical research, this paper will

demonstrate that the 2008 financial crisis was a reflection

of the excess of liquidity created by Asian countries,

after the financial crisis of 1997.

The Great Depression (1929):

Experts, policymakers, and macroeconomists often

remind us that banking crises are “nothing new” to argue

that crises are built into the business cycle or human

nature. Charles Kindleberger (1973) and Hyman Minsky

(1975), for instance, were strong promoters of this view.

According to them, banking crises is a consequence of the

predisposition of market participants for irrational

reactions and shortsighted anticipation. Most Americans

today have heard that debt is seen as one of the causes of

the Great Depression. But most don't know what is behind it

and that the lessons learned “then” that can be applied

“now.”

Similarly to the years that preceded the 2008

financial crisis, the years before the Great Depression

meant a long period of prosperity with an unusual number of

everyday Americans gambling on Wall Street.5 Something

5
Sheng, Andrew. “An Asian View of the Global Financial Crisis.”
Caijing Magazine
http://english.caijing.com.cn/2008-12-22/110041238.html

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called "margin" kept this financial machine going.

Basically you could buy stock on credit, purchasing a

thousand dollars worth of shares with just a hundred

dollars down. Once the stock went up you could sell it at a

big profit, pay off the loan and keep the rest. So as long

as the market kept going up, everyone made a lot of money.

However, stocks started going down. There was much "margin

call" - time to pay up for the stock (bought for 10%

down). People did not have the money, especially because

they had to sell the stock at a big loss, and the margin

call increased the collapse of the market and the banks

that funded all that buying. As the banks started

collapsing under the weight of all that unpaid debt,

depositors ran to get their money out. That accelerated

the fall of the banks, leaving millions of Americans

broke.6

There are two views of the Great Depression.

Monetarists, including Milton Friedman and Ben Bernanke,

argue that monetary contraction caused the Great

Depression: the consequence of poor policymaking by the

American Federal Reserve System and continuous crisis in

the banking system. In this view, the Federal Reserve, by

not acting, allowed the money supply shrink and large

6
“U.S. 1929 Great Depression vs.2008 financial, housing, credit
crisis.” InvestmentWatch. 12 November, 2008, 11:46 pm
http://investment-blog.net/us-1929-great-depression-vs-2008-financial-
housing-credit-crisis/

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public bank failures produced panic and widespread runs on

local banks. Friedman argues that the falling turn in the

economy, starting with the stock market crash, would have

been just another recession if the Federal Reserve had

intervened. According to Friedman, had the Fed provided

emergency lending to these key banks, or simply bought

government bonds on the open market to sustain liquidity

and increase the quantity of money after the key banks

fell, all the rest of the banks would not have fallen after

the large ones did, and the money supply would not have

fallen as far and as fast as it did.7

Keynesians, on the other hand, argue that the central

bank should have expanded the money supply. According to

them, by putting more bills in people's hands consumer

confidence would return, people would spend, and the

circular flow of money would have been reestablished.

Keynes believed that depressions were recessions that had

fallen into a "liquidity trap." A liquidity trap is when

people save money and refuse to spend no matter how much

the government tries to expand the money supply. According

to Keynes, in these circumstances the government should do

what individuals were not doing: spend money, preferably on

social programs to reestablish the circular flow of money.8

7
“U.S. 1929 Great Depression vs.2008 financial, housing, credit
crisis.” IBID.

8
“A Review of Keynesian Theory.”
http://www.huppi.com/kangaroo/Keynesianism.htm

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Economists of the classical school (thought that

dominated macroeconomic thinking before the Great

Depression) saw the crash that occurred in much of the

world in the late 1920s and early 1930s as something

abnormal that would not persist. “The economy would right

itself in the long run and return to its potential output

and to the natural level of employment.”9 But the economy

did not return to its potential output by itself and we saw

slumps with similar characteristics occurring, in different

parts of the world, in the following years.

The Asian Financial Crisis (1997):

In 1997 the Thai currency devaluation, baht, triggered

a financial avalanche that affected good part of Asia. The

problem started in 1980s, when foreign companies

(especially Japanese) started to install fabrics in

Thailand, transforming the country into an industrial

center. Typically a Japanese bank would grant a loan to a

Thai “financial company”, institution which main objective

was to act as treadmill of foreign funds. This Thai

financial company would then have ienes that would be

passed to a local real-estate developer, through a new loan

with higher fees. However, the Thai company wanted to

contract the loan in baht, not in ienes because it needed

9
Tregarthen,Timothy and Libby Rittenberg. “Principles of
Macroeconomics.” 1969. Flat World Knowledge. 1 Jan, 2010.
<http://www.flatworldknowledge.com/node/29936>.

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to buy land and pay the workers in local currency.

Consequently, the Thai financial company would go to the

exchange market and exchange ienes for baht. The exchange

market as all other markets is governed by supply and

demand, so the demand for baht by the Thai financial

company tended to elevate the value of baht in comparison

with the other currencies.10

During the boom the central bank of Thailand was

engaged in maintain the exchange rate stable between the

baht and the American dollar. Therefore, the direct effect

of that first loan in iene was the increase in the

international reserves of the Bank of Thailand and in the

money supply in the Thailandese economy as well in the

expansion of credit in the economy – as consequence not

only of the loan granted directly by the financial company,

but also as consequence of the new loans granted by banks

in which the supply of currency was incremented. As good

part of the loans conceded by the banks ended up returning

to the own banks in form of new deposits, the same original

quantity financed new loans through a classical process

called “money multiplier”. The crescent ingress of

external loans in the economy expanded the credit, which

11
triggered a new wave of investments.

10
“The 2008 Financial Crisis and the Economics of Depression.”IBID.Pg.
11
IBID. Pg.82

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Good part of these investments was concentrated in

civil and residential construction and commercial

buildings. But another good part was destined to pure

speculation - speculation in real estate, but also with

actions.12 In the beginning of 1996, the economies of

Eastern Asian were beginning to present strong similarity

with the Japanese “economic bubble” in the end of 1980s.

The monetary authorities of Thailand attempted to contain

the outbreak speculative by sterilizing the ingress of

capital. But the attempt was a failure and the credit

continued in expansion. Finally the expansion of the

currency and the credit met its limits and the spike in

investment as well as the surge of new spending by affluent

consumers, triggered a new wave of imports, while the

economic prosperity increased wages, making Thai exports

less competitive.13

Differently from what economists said at the time, the

Asian financial crisis was not a specific phenomenon with

peculiar characteristics of that region.

2008 financial crisis: a reflection of the 1997 Asian

Crisis

The collapse of housing prices and the subprime

mortgage market in the United States were not the causes of

12
IBID.
13
IBID.pag.83

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the 2008 financial crisis. These were themselves

consequence of another problem. The real reasons behind of

the crisis were the combination of very low interest rates

and remarkable level of liquidity. The low interest rates

mirrored the American government extremely generous

monetary policy after 9/1114. The liquidity reflected,

among other factors, what Federal Reserve Chair Ben

Bernanke referred as “the global savings glut.” It means

the huge financial surpluses realized by countries like

China, Singapore and the oil-producing states of the

Persian Gulf.

Until the mid-1990s, most developing economies ran

balance-of-payments deficits as they imported capital to

finance their growth. But the Asian financial crisis of

1997-98 changed this scenario in much of Asia. After the

Asian crisis of 1997-98 surpluses grew throughout the

region and were constantly recycled back to the West in the

form of investments. Confronted with low profits this huge

amount of liquidity logically sought higher ones, so an

enormous amount of capital flowed into the subprime

mortgage sector and toward weak borrowers15 of all types,

14
The U.S. Federal Reserve reduced the federal funds rate to almost
one percent in late 2001 and maintained it near that very low level
for three years.
Altman, Roger. “The Great Crash, 2008 A Geopolitical Setback for the
West.”Foreign Affairs. January/February. Pag. 2

15
It is known that homebuyers should not contract housing finance
which installments are beyond their financial capacity. But in 2007
there was a change in the grants of loans to homebuyers, such as
remission or reduction in the entry and increase in the monthly

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especially in the United States and in Europe. The volume

of U.S. subprime and other securitized mortgages rose from

$100 billion approximately to over $600 billion in 2005 and

2006. “As with all financial bubbles, the lessons of

history, including about long-term default rates on such

poor credits were ignored.”16 This abundance of mortgage

money caused residential and commercial real estate prices

to rise at abnormal levels. While the normal average U.S.

home had enjoyed 1.4 percent annually over the 30 years

before 2000, this rate soared to 7.6 percent annually from

2000 through mid-2006.17

In sum, the 2008 financial crisis was a combination of

three important factors, global imbalances (Bernanke's

savings glut), low interest rate policy by the Fed, and the

failure of markets and regulators to provide the checks and

balances necessary to prevent the crisis from occurring.

The difference between 1929 and 2008 was that back then we

had an oversupply of cars and radios bought on credit that

deflated. This time we had an oversupply of houses and

installments to values away far superior to the capacity of payment of

the borrowers – or those would become too high in case the government
increased the rates. Homebuyers became negligent to the classical
principles because of believe of constantly valuation of houses. As
far as the price of houses increased constantly, the capacity of
payment of the debtor, from the point of view of the creditor, would
not be very relevant.
Krugman, Paul. IBID.
16
Altman, Roger. “The Great Crash, 2008”. Foreign Affairs.
January/February 2009. Pg.4.
17
Altman, Roger. Ibid.

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mortgage backed securities bought on credit that have

deflated.

Concluding Remarks:

Robert Lucas of the University of Chicago and Ben

Bernanke from the FED preemptively claimed in 1985 that

modern macroeconomics had already solved the problem of

economic cycles. According to them, macroeconomics should

no longer be considered a priority. However, Japan spent

most of the 1990s in an economic trap and the smaller Asian

18
countries plummeted from prosperity to calamity in 1997.

To complete, the narratives of this last financial

catastrophe of 2008 seemed to be taken directly from the

financial history of the 1930´s.19

Some economists argue that the 1997/98 Asian crisis

was different from the 2008 crisis because it was

essentially a traditional retail banking crisis together

with a currency crisis. Meanwhile, according to them, the

2008 financial crisis was a truly wholesale banking crisis

with huge derivative amplification effects. Economists

also point as another difference the fact that, unlikely

the 2008 financial crisis, the Asian crisis was still a

crisis at the periphery - while the 2008 financial crisis

was a crisis at the center of global finance.

18
Krugman, Paul. IBID. Pg 15.
19
Krugman, Paul. IBID. Pg. 5

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Clearly the effect of the Asian financial crisis of

1997 cannot be compared with the effect of the 2008

financial crisis on the rest of the world. The world

economy then, in 1997, was not as interconnected as it is

today and Asia was not economically important as it is now.

Moreover, the amplification effect of the 2008 financial

crisis not only covered the two dominant powers, US and

Europe, but also was significantly larger and deeper.20

Kenneth S. Rogoff of Harvard University wrote a paper

about the 2007 Subprime Crisis, in which he mentioned a

classic novel of Tolstoy, Anna Karenina: “Every happy

family is alike, but every unhappy family is unhappy in

their own way.” That was the way of Rogoff to assert that

while each financial crisis, clearly, has its own

differences, there are also impressive similarities, “in

the run-up of asset prices, in debt accumulation, in growth

patterns, and in current account deficits.”21

By affirming that modern macroeconomics had already

solved the problem of economic cycles, economists were

clinging to that thought in vogue until the Great

Depression where most economists embraced the vision of

capitalism as a perfect or nearly perfect system.

20
“An Asian View of the Global Financial Crisis.” IBID.

21
M. Reinhart, Carmen and S.Rogoff, Kennedy. “Is the 2007 US Sub-Prime
Financial Crisis So Different? An international Historical
Comparison.” January 6, 10:15 AM Session: New Perspectives on
Financial Globalization (AEA).
http://www.aeaweb.org/annual_mtg_papers/2008/2008_578.pdf

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Economists saw that vision was not sustainable, but as

memories of the Great Depression disappeared, they fell

back in love with the idealized vision of an economy in

which rational individuals interact in perfect markets.22

The failure on the demand side of the economy - failure of

private spending to use the productive capacity available –

not only proved that modern macroeconomics did not solve

the problem of economic cycles, but it is now a limiting

factor to economic prosperity in much of the world.23

BIBLIOGRAPHY:
1. “A Review of Keynesian Theory.”
http://www.huppi.com/kangaroo/Keynesianism.htm

22
“An Asian View of the Global Financial Crisis.” IBID.

23
Krugman, Paul. IBID. pg.192.

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2. Altman, Roger. “The Great Crash, 2008 A Geopolitical

Setback for the West.”Foreign Affairs.
January/February.

3. Baldwin, Richard. “Calomiris on historical crisis

lessons.” November, 4th 2009.

4. Krugman, Paul. “How Did Economists Get It So Wrong?”

The New York Times. September 2,2009.

5. Krugman, Paul. “The 2008 Financial Crisis and the

Economics of depression.”2009, Elsevier Editora Ltda.
Brasil

6. M. Reinhart, Carmen and S.Rogoff, Kennedy. “Is the

2007 US Sub-Prime Financial Crisis So Different? An
international Historical Comparison.” January 6, 10:15
AM Session: New Perspectives on Financial
Globalization (AEA).
http://www.aeaweb.org/annual_mtg_papers/2008/2008_578.
pdf

7. Sheng, Andrew. “An Asian View of the Global Financial

Crisis.” Caijing Magazine

8. “Political Economy and the Financial Crisis.”

Stratfor.com.

9. Tregarthen,Timothy and Libby Rittenberg. “Principles

of Macroeconomics.” 1969. Flat World Knowledge. 1 Jan,
2010.

10. “U.S. 1929 Great Depression vs.2008 financial,

housing, credit crisis.” InvestmentWatch. 12 November,
2008, 11:46 pm.

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Du Miracle de L’asie à la (Re)Orientation Du Monde

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